Austrian Business Cycle Theory

The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics about how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit, due to artificially low interest rates set by a central bank or fractional reserve banks. The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory.

Proponents believe that a sustained period of low interest rates and excessive credit creation result in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: low interest rates tend to stimulate borrowing from the banking system. This leads to an increase in capital spending funded by newly issued bank credit. Proponents hold that a credit-sourced boom results in widespread malinvestment. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when the credit creation has run its course. Then the money supply contracts (or its growth slows) causing a curative recession and eventually allowing resources to be reallocated back towards their former uses.

The Austrian explanation of the business cycle differs significantly from the mainstream understanding of business cycles and is generally rejected by mainstream economists. Mainstream economists generally do not support Austrian school explanations for business cycles, on both theoretical as well as empirical grounds.

According to ABCT, a period of "malinvestment" is caused by a period of excessive business lending by banks, and this credit expansion is later followed by a sharp contraction and period of distressed asset sales (liquidation) which were purchased with overleveraged debt. The initial expansion is believed to be caused by fractional reserve banking encouraging excessive lending and borrowing at interest rates below what full reserve banks would demand. Due to the availability of relatively inexpensive funds, entrepreneurs invest in capital goods for more roundabout, "longer process of production" technologies. Borrowers take their newly acquired funds and purchase new capital goods, thereby causing an increase in the proportion of aggregate spending allocated to capital goods rather than consumer goods. However, such a shift is inevitably unsustainable over time due to mispricing caused by excessive credit creation by the banks and must reverse itself eventually as it is always unsustainable. The longer this distorting dislocation continues, the more violent and disruptive will be the necessary re-adjustment process.

...
Wikipedia